Hefty tax bill may hit those who lost home

San Diegans who have lost their homes through foreclosure or short-sales thought they had emerged from the dark times and could start rebuilding their lives.

Then the state tax man came calling.

With less than six weeks before taxes are due, an estimated 16,000 former homeowners statewide will owe $15 million in extra income taxes this year and $29 million through 2012.

The tax applies to what is called the “cancellation of debt” that occurs when property owners lose their homes through foreclosure or arrange a short-sale in which they sell for less than the mortgage balance. The lender sends them a form itemizing the forgiven debt, and the amount is subject to income tax.

Congress exempted most homeowners from the extra federal tax through 2012, and the state followed suit for 2007 and 2008 but did not extend the provision last year. The state Assembly may vote tomorrow on a bill to repeal the tax, but Gov. Arnold Schwarzeneggervetoed such a bill last year over unrelated provisions.

“They’re probably stuck,” San Diegotax attorney Bob Kevane said of former homeowners facing the tax. “The biggest way around it is if you’re insolvent.”

Brad Nemeth, another tax attorney, said he doubts the tax will be eliminated.

“The state of California is seriously upside down financially, and I think the governor will probably veto it again,” Nemeth said.

H.D. Palmer, a spokesman for the Department of Finance, said Schwarzenegger remains opposed to the bill in its present form but has not announced whether he will veto it again. Other versions of the tax repeal are in the hopper and could be passed next month, legislators’ analysts said.

Failure to halt the tax could cost Jack and Phyllis Roth of Fletcher Hills as much as $20,000 in state income taxes this year — they paid $781 last year — because of the home they sold short in Flinn Springs in November. They bought it in 2004 for $545,000, invested $50,000 in improvements, and then saw its value fall by one-third before they sold it for $410,000. The result was about $190,000 in net loss that was forgiven by the Roths’ lender.

Phyllis Roth, 63, a tax preparer, said she did not realize until recently that the state would treat the short-sale differently than the Internal Revenue Servicewould. She estimates her state taxes at $15,000 to $20,000.

“I didn’t call anybody,” she said. “I was looking online and didn’t see anything. That’s what happens when you rely on yourself.”

The state Franchise Tax Board has received an increasing number of calls from former homeowners who are discovering the giant tax bills they face, said spokeswoman Denise Azimi. Azimi said the former homeowners can work out a payment schedule, though the state charges 4 percent interest on such stretched-out payments.

If the tax is repealed eventually, the taxpayers could seek a refund, but for now, they have to pay what is due by April 15 or face a penalty.

Not all foreclosures and short-sales are subject to the tax, experts said.

In California, most home buyers get mortgages involving a “nonrecourse” loan — meaning that if the property is foreclosed, the lender has no recourse for recovering lost money except by selling the property itself. Lenders cannot go after the owners’ assets to make up the difference, and no tax is due. These rules apply to principal residences only.

However, when owners refinance or take out a second mortgage or home equity line of credit — as happened often during the housing boom — those loans are written as recourse loans and lenders can seek repayment from the owners’ other resources. Sometimes lenders agree to waive the lost amount, but under current state law, that amount is taxable for homes sold since Jan. 1, 2009.

“It’s one of those little land mines waiting to jump up on people,” Nemeth said.

Taxes also are not due if owners declare insolvency or bankruptcy, the lawyers said. For young homeowners whose main asset was their home, it’s likely they could fall under this provision. For others, the valuation of assets becomes a factor in determining solvency.

“Sometimes if they have other real estate, we try and value the stuff realistically, so that they have as little impact as possible,” Kevane said.

For the Roths, who continue to own a previous home and have other assets, their nearly $200,000 in losses does not cancel out their other holdings. The couple said they normally operate conservatively and only bought the home, which they lived in while their son continued to live in their first house, so they could sell it at a profit and pad their retirement accounts.

“If we have to pay it, we’ll pay it,” Phyllis Roth said of the taxes. “It’s less money to retire on, but it’s not the end of the world.”

Back in Sacramento, the proposal to waive the cancellation of debt tax has passed the Senate and awaits an Assembly vote. Its fate is wrapped up in a larger bill, SB8X-32, by Sen. Lois Wolk, D-Davis, which would bring other state tax provisions into compliance with federal law.

One of those, which prompted Schwarzenegger’s veto last year, relates to “erroneous reporting” of tax liability, by which some large taxpayers seek to avoid penalties for under-reporting of income by overestimating taxes due. Federal law charges a penalty for overestimating without a reasonable explanation, and the state bill would adopt similar penalties.

Wolk, who chairs the Senate Revenue and Taxation Committee, said it was appropriate to group all tax conformance measures into one bill. But if her bill is vetoed again, she indicated she would act to get the cancellation of debt tax repealed.

“We’re certainly not going to allow homeowners to have to pay significantly more tax when they’ve had to relinquish their homes through short-sales (and foreclosures),” Wolk said.